Exchange Traded Funds (ETF)
ETFs are exchange traded funds that hold multiple underlying assets, such as stocks, bonds, commodities, or currencies. They are traded on public stock exchanges like individual stocks, but they offer diversification benefits like index funds or mutual funds. ETFs can track various indexes, sectors, markets, or strategies, and they often have lower fees and taxes than actively managed funds. ETFs can be a convenient and flexible way to invest in different asset classes and markets.
2023 Best ETFs to invest in
- Invesco S&P 500 Equal Weight Real Estate ETF (EWRE)
- iShares Core S&P 500 ETF (IVV)
- Vanguard Long-Term Bond ETF (BLV)
- Vanguard Small-Cap Value ETF (VBR)
- SPDR S&P Biotech ETF (XBI)
- always do your own research
Examples of ETFs that cover different asset classes, regions, sectors, themes, and strategies.
Equity ETFs these ETFs invest in stocks of companies from various countries or industries. For example, Schwab U.S. Large-Cap ETF (SCHXM) tracks the performance of large U.S. companies, Global X Robotics & Artificial Intelligence ETF (BOTZ) invests in companies that are involved in robotics and artificial intelligence, iShares Global Clean Energy ETF (ICLN) holds stocks of companies that produce energy from solar, wind, and other renewable sources.
Bond ETFs these ETFs invest in fixed income securities such as government bonds, corporate bonds, municipal bonds, etc. Example, Vanguard Total Bond Market ETF (BND) provides exposure to the entire U.S. bond market, iShares iBoxx $ High Yield Corporate Bond ETF (HYG) focuses on high yield or junk bonds, SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL) invests in short term U.S. Treasury bills.
Commodity ETFs these ETFs invest in physical commodities or futures contracts on commodities such as gold, silver, oil, natural gas, etc. Example, SPDR Gold Trust (GLD) holds gold bars in a vault, United States Oil Fund LP (USO) tracks the price of crude oil, Invesco DB Agriculture Fund (DBA) follows a basket of agricultural commodities such as corn, wheat, soybeans, etc.
Currency ETFs these ETFs invest in foreign currencies or currency pairs that reflect the exchange rates between different countries. Example, Invesco CurrencyShares Euro Trust (FXE) holds euros, WisdomTree Chinese Yuan Strategy Fund (CYB) tracks the value of the Chinese yuan, Invesco DB US Dollar Index Bullish Fund (UUP) follows a basket of currencies that trade against the U.S. dollar.
Difference between an equity ETF and a stock
An equity ETF is a type of fund that holds multiple stocks of different companies, while a stock is a share of ownership in a single company. An equity ETF can provide diversification and exposure to a specific market segment or industry, while a stock can offer higher potential returns and more control over your investment.
An equity ETF also has lower costs, more liquidity, and more tax efficiency than a stock. The choice between an equity ETF and a stock depends on your risk tolerance, investment goals, and personal preferences.
Benefits of investing in ETF
Trading flexibility ETFs trade like stocks on an exchange, which means you can buy and sell them throughout the day at market prices. You can also use different types of orders, such as limit orders or stop-limit orders, to execute your trades at your desired price or time. This gives you more control and convenience than traditional mutual funds, which trade only once a day at their net asset value (NAV).
Lower costs ETFs typically have lower operating costs than mutual funds because they are passively managed and track an index or a basket of securities. They also have lower transaction costs because they do not charge sales loads or commissions. You may still incur brokerage fees or bid ask spreads when trading ETFs, so you should compare the total costs of different ETFs before investing.
Tax efficiency ETFs are generally more tax efficient than mutual funds because they do not distribute capital gains frequently. This means you can defer paying taxes on your gains until you sell your ETF shares. Some ETFs may allow you to avoid foreign withholding taxes on dividends by holding stocks directly rather than through an intermediary.
Drawbacks of investing in ETFs
Less diversification some ETFs may not provide enough diversification for some sectors or foreign stocks, as they may only track a narrow group of large cap stocks that represent a market index. This could limit your exposure to different segments or styles of investing. Some ETFs may hold too many securities that dilute your returns or increase your risk.
Intraday pricing ETFs trade throughout the day at market prices that fluctuate based on supply and demand. This could be beneficial for short term traders who want to take advantage of price movements, but it could also be a disadvantage for long term investors who do not need intraday pricing changes and may face higher volatility or lower liquidity.
Costs ETFs generally have lower costs than mutual funds, they are not free. You may have to pay brokerage fees or bid ask spreads when trading ETFs, which could eat into your returns. Also, some ETFs may have higher operating expenses than others due to their management style or complexity. You should compare the total costs of different ETFs before investing.
Tracking errors some ETFs may not perfectly track their underlying index or basket of securities due to various factors such as fees, rebalancing, market disruptions, etc. This could result in a performance gap between the ETF and its benchmark, which could be positive or negative depending on the situation. You should check the tracking error of an ETF before investing.
More about tracking errors
Tracking error is a measure of how closely an ETF follows its benchmark index or basket of securities. It is calculated by subtracting the ETF’s return from the benchmark’s return over a given period.
Example, Suppose an ETF tracks the S&P 500 index, which offers a 10% return over one year. If the ETF offers a 9.8% return over the same period, then its tracking error is -0.2% (9.8% - 10%). This means that the ETF underperformed its benchmark by 0.2 percentage points.
Suppose another ETF tracks the Nifty 50 index, which offers an 8.6% return over one year. If the ETF offers an 8.9% return over the same period, then its tracking error is 0.3% (8.9% - 8.6%). This means that the ETF outperformed its benchmark by 0.3 percentage points.
A low tracking error indicates that an ETF closely follows its benchmark and has low risk of deviating from it, a high tracking error indicates that an ETF diverges significantly from its benchmark and has high risk of deviating from it.
Investing in ETFs involves some risks that you should be aware of before buying them.
Market risk this is the risk that the market or sector that your ETF tracks goes down in value, affecting your returns. Market risk can be influenced by various factors, such as economic conditions, political events, natural disasters, etc. You can reduce market risk by diversifying your portfolio across different asset classes and regions.
“Judge a book by its cover” risk this is the risk that your ETF does not perform as expected based on its name or description. For example, an ETF that claims to track a certain index may have different holdings or weightings than the index itself, or an ETF that claims to offer exposure to a certain theme or strategy may have hidden fees or risks. You can avoid this risk by reading the prospectus and fact sheet of your ETF carefully and understanding its objectives, methodology, costs, and risks.
Exotic exposure risk this is the risk that your ETF invests in assets that are complex, illiquid, volatile, or hard to value. For example, some ETFs use derivatives, leverage, inverse strategies, or alternative assets that can magnify losses or deviate from their benchmarks. You can minimize this risk by sticking to plain vanilla ETFs that track well-known indexes or asset classes and avoiding products that you do not understand fully.
Tax risk this is the risk that your ETF generates unexpected tax liabilities for you. While most ETFs are tax efficient compared to mutual funds because they do not distribute capital gains frequently, some ETFs may have different tax treatments depending on their structure and holdings. Example, some bond ETFs may pay interest income that is subject to ordinary income tax rates rather than lower dividend tax rates, some commodity ETFs may generate K-1 forms that complicate your tax filing, some foreign ETFs may incur withholding taxes on dividends paid by foreign companies. You can reduce tax risk by consulting a tax professional before investing in any ETF and choosing products that suit your tax situation.
Comparing different ETFs
Management-expense ratio (MER) this is the percentage of your investment that goes to pay for the ETF’s operating costs, such as management fees, administrative fees, etc. The lower the MER, the more of your money goes to work for you. The MER is the most reliable predictor of future performance for investment funds, and ETFs are no exception–that is, cheap funds, on average, tend to be better performers than those that are more costly.
Index construction and underlying holdings this is how the ETF tracks its benchmark index or basket of securities. You should look at how the ETF selects and weights its holdings, whether it uses full replication (holding all the securities in the index) or sampling (holding a representative sample of securities), whether it uses physical or synthetic replication (holding actual securities or derivatives), etc. You should also look at what sectors, countries, styles, etc. are represented in the ETF’s portfolio and how they match your investment objectives.
Commissions to buy and sell this is how much you pay to your broker or platform when you trade ETFs. You should compare different brokers or platforms based on their commission rates and minimum charges. Some brokers or platforms may offer commission-free trading for certain ETFs or accounts.
Bid/Ask spread this is the difference between the highest price someone is willing to pay (bid) and the lowest price someone is willing to sell (ask) for an ETF on the market. The narrower the spread, the less you pay when you buy or sell an ETF. The spread may vary depending on factors such as liquidity (how easily an ETF can be traded), volatility (how much an ETF’s price fluctuates), market conditions (such as supply and demand), etc. You should avoid trading during volatile periods when the spread may be wider.
Premium/discount this is how much an ETF’s market price differs from its net asset value (NAV), which is calculated by dividing its total assets minus liabilities by its number of shares outstanding. A premium means that an ETF’s market price is higher than its NAV; a discount means that an ETF’s market price is lower than its NAV. A small premium or discount may reflect normal market forces, a large premium or discount may indicate inefficiencies or risks in an ETF’s structure or operations.
How to buy ETFs
Open a brokerage account, (Webull - Robinhood) you need a brokerage account to buy and sell securities like ETFs. You can choose a full service account, where you will have access to a financial advisor who will give you advice and buy the ETFs on your behalf, or a self-directed account, where you will have more control and lower fees but also more responsibility. You should compare different brokers or platforms based on their costs, features, customer service, etc. before opening an account.
Decide on your ETF investment strategy, once you have a brokerage account, you need to decide how you want to invest in ETFs. You can use ETFs to diversify your portfolio, target specific market segments or industries, follow a passive or active strategy, etc. You should also determine your risk tolerance, investment goals, time horizon, and budget before choosing your ETFs.
Research your ETFs, once you have decided on your strategy, you need to research different ETFs that suit your needs. You can use screening tools or websites that provide information about various aspects of ETFs such as their performance history, holdings, fees, tracking error, dividend yield, etc. You should also look at their name or ticker symbol (a short code that identifies them on the stock market), as well as how much you want to buy in terms of units or total pounds invested.
Place the trade, once you have selected your ETFs, you need to place the trade through your broker or platform. You can use different types of orders such as market orders (which execute at the current price) or limit orders (which execute at a specified price or better). You should also check the bid-ask spread
Monitor and rebalance your portfolio once you have bought your ETFs, you need to monitor their performance and adjust your portfolio accordingly. You may want to rebalance your portfolio periodically (such as quarterly or annually) to maintain your desired asset allocation and risk level. You may also want to sell some of your ETFs if they no longer meet your criteria or goals.